Introduction to Derivatives

Slide 2: Welcome to reading 60 of the Simplilearn CFA Level I tutorial. This will be a session on derivatives – one of the important concepts in the field of investments. Derivatives are widely used as a risk management tool in portfolio management. As the name suggests these instruments derive their price from underlying securities such as stocks, bonds, currency, interest rates or even commodities like gold and crude. The session will be divided into 6 lectures. Today we will cover the 1st lecture which is the basic introduction of derivatives and the derivatives markets. Let us begin our discussion.

Slide 3: Agenda

The main agenda of our discussion will be to give you a brief idea about the derivatives market and features of the major derivatives such as forwards, futures, options and swaps. In each of the subsequent lectures we will learn in detail about each of these derivatives. We will begin the session by learning about the types of derivatives markets. We will then learn in brief about forwards, futures, options and swaps. Finally we will learn about the purpose of derivatives markets and the arbitrage theory.

Slide 4: Types of Derivatives

OTC or over-the-counter transactions are very popular in larger trades. Currently the OTC transactions are several times larger in volume than the exchange transactions. OTC transactions have an advantage of being flexible as terms and prices can be negotiated between parties. In exchange transactions terms are standardized and the exchange acts as in intermediary between the parties and collects “margins” from both the parties such that both are protected from default from the other party. However terms cannot be negotiated in such transactions.

Slide 5: Forwards vs. Futures

The derivatives market consists mainly of Forwards, Futures and Options. These are contracts to purchase or sell any asset on a future date i.e. actual transaction is not carried out until the specific date or expiry date. To understand suppose a buyer agrees to purchase 100 shares of XYZ on 30th of next month at an agreed price of say $50, then on the 30th of next month the seller has to deliver 100 stocks to the buyer at $50 per stock irrespective of the price at that time. Suppose the price on 30th is $60 then the buyer can instantly generate $10 profit per share by selling the delivered stocks in the market. If the price on the 30th is $40 then the buyer is at a loss of $10 per stock. In both cases one party gains while other loses i.e. it is a zero sum game.In forward contracts the date, terms and conditions are negotiated one-on-one basis and carried out on OTC markets as in example above. If the terms and prices are decided by the exchange and transactions are carried out over the exchange it is called a futures contract. Usually both the parties need to deposit “margins” on regular basis depending on their position so that default risk is eliminated on the expiry date. Hence the futures markets are more standardized and have lower default or credit risk.

Slide 6: Options

Options on the other hand give the buyer the option to either carry out the transaction or just “walk away” if there is a loss. In such a case the buyer forgoes the initial contract amount that is paid upfront to the seller of the contract. To understand consider an example in which the buyer purchase a contract to buy XYZ stock at $50 on 30th of next month. Initially, the buyer pays $10 for entering this option contract. Suppose the price is $65 then the buyer will exercise the option as he will get the stock at $50 and sell at $65. As he initially paid $10 so the net gain=$65-$(10 Plus 50) =$5. Hence the buyer is in profit if the price is at least above the (contract price Plus option price). In case the price is $30 the buyer can just walk away with a loss of only $10 (option price) rather than a loss of $20 (in case of Futures/Forward contract). The options are of two types – Calls and Puts. A call option is an option to purchase an asset on a later date (expiry date) at an agreed price called the strike price. If on the expiry date the price of the asset is more than the agreed price then the purchaser of the option is in profit as he can get the asset at a lower agreed price and sell at the higher market price. However the difference must be sufficient to recover the initial non-refundable option cost paid up front. A put option is an option to sell an asset on a later date (expiry date) at an agreed price called the strike price. If on the expiry date the price of the asset is less than the agreed price then the purchaser of the option is in profit as he can purchase the asset at a lower market price and sell at the higher agreed price. However the difference must be sufficient to recover the initial non-refundable option cost paid upfront

Slide 7: Swaps

Let’s now discuss swaps. Imagine that one person is holding a semiannual bond that pays 4 Percent coupon on a principal of $10,000. This person receives a fixed payment of $2000 every six months as coupon payments as shown. Consider another person holding a bond that pays floating interest based on six month LIBOR. Suppose interest rates for next 3 periods are 4 Percent, 4.5 Percent and 4.8 Percent then this person will receive $2000, $2250 and $2400 every six months. Now they mutually agree and enter into a contract such that person receiving fixed payment will pay this fixed payment to the person receiving floating payment and in return the other person will pay the floating payment to the first person. The net payment is shown in the chart. Therefore the contract enables parties to interchange their cash flow liabilities. We also find that the net payment is positive for one party and negative for other. As such the present value of the net positive payment to one party becomes the value of the initial contract known as the value of the swap. The agreement is termed as a swap.

Slide 8: Purpose of Derivatives Markets

Let us now learn about the purpose of derivatives markets. Derivatives markets give the opportunity for price discovery of assets such as stocks. The nearest term futures price act as a proxy for the underlying price. Futures prices for periods in the future substitute for the uncertainty in the price in future. Options prices act as indicators for the volatility rather than the price of the asset. We can use methods such as the Black Scholes Merton method to estimate the implied volatility from the options current price. Derivatives market serves another purpose of risk management. Traders can hedge their position through derivatives such as options and futures. We will learn about various hedging strategies in upcoming slides.

Slide 9: Arbitrage and Market efficiency

Arbitrage means earning riskless profit by entering into two equal and opposite trades at the same time. This occurs when the assets sells at two different prices. Pricing of efficient markets are based on the “Law of One Price” i.e. equivalent assets cannot be sold at different prices or there is no opportunity for arbitrage. If any opportunity exists then it is for a very short time and prices adjust quickly to remove any arbitrage opportunity. Let us now take an example to demonstrate arbitrage. A person borrows $1000 at 4 percent interest rate and invests in stocks. He also shorts 3 month futures of the same stock. At the end of 3 months he delivers the stocks at the futures price and returns the borrowed money. From the law of one price, the futures price must be equal to the borrowed money plus the interest or else there will be an opportunity to earn riskless profit.